What is quantitative easing? Definition and application

In 2015, the European Central Bank has rolled out a bond-purchase program worth more than €1.1 trillion in its attempt to stimulate economies across the crisis-stricken European Union. This specific economic policy is called quantitative easing and, although technical in nature, the concept is rather simple despite its sophisticated-sounding name.

By definition, quantitative easing is a monetary policy used by a central bank to replace a standard monetary policy and stimulate the economy.

Origins of quantitative easing as an economic policy

The policy originated from Japan during the earlier years of the new millennium, particularly when the Bank of Japan developed and implemented a new framework for easing monetary supply beginning 2001.

Quantitative easing involved using purchased Japanese government bonds as main financial instrument for satisfying projections in current account balances held by other banking institutions operating under the regulatory control of the Bank of Japan.

The Bank of Japan successfully used the policy to inject funds in banks that in turn, became cash reserves. This increased the monetary supply in circulation.

Ultimately, quantitative easing was projected to address critical deflation rates. It is important to note that the Bank of Japan and thus, the Japanese government developed and implemented the policy to salvage the weakening Japanese economy.

The United States government has also implemented quantitative easing as part of its numerous policies aimed at saving its economy from the dreaded and dragging effects of the 2008 Financial Crisis. As of 2014, the Federal Reserves has now pumped trillions of dollars in the U.S. financial system.

What is quantitative easing: A further definition

Remember that monetary policy is an economic policy aimed at stimulating economic growth or driving economic contraction by controlling the supply of money, availability of money, and interest rates.

Quantitative easing is an unconventional monetary policy, nonetheless. Technically, it involves using purchased assets or financial instruments from other banking or financial institutions to generate cash for subsequent injection in the reserves.

For a simplistic definition, the policy is akin to “printing money” or producing monetary supply. However, instead of producing actual legal tenders such as coins and notes, a central bank buys “assets” or more importantly, debts (such as treasury bills, bonds, and mortgage bank security paper) of banking and financial institutions. This gives banks funds.

The main purpose behind giving banks funds is for them to increase lending to households and businesses and thereby, increase the supply of money in circulation and in the economy. It also promotes an ideal level of inflation.

However, unlike a standard monetary policy that results in lower interest rates and an increase monetary supply, quantitative easing cannot lower interbank rates further because they are already at 0%. The policy is actually just another term or label to denote a monetary policy that merely “eases” the “quantity” of money.

Effects of quantitative easing in the economy

Ideally, lending drives economic activity and economic growth as households and businesses use their borrowed money in various investments and productivity-related endeavour. The money pumped in circulation also keeps deflation at bay. More money simply means more buying power for the public. Quantitative easing intends to replicate or stimulate this phenomenon. However, critics are doubtful of its lasting impacts.

A report by Norbert J. Michael and Stephen Moore of The Heritage Foundation concluded that the policy is ineffective simply because it merely increases the amount of excess reserves in the entire banking system. To be specific, instead of using the funds to increase lending to households and businesses, banks might resort to keep them.

The Economist also has warned against quantitative easing. Because the policy increases cash reserves of banks, it can encourage irresponsible banking activities. Banks might become too lenient in extending banking services, especially lending services to individual and business consumers.

In Japan, according to S. Perlin Berkmen and the International Monetary Funds, despite its long experience with quantitative easing, researches revealed mixed results that moreover, collectively lean toward limited effects on economic activity. Although some researchers point out that quantitative easing can help in reducing yields, inflation rate in Japan currently remains below the ideal level. Of course, on a positive note, quantitative can stimulate several economic activities by creating a viable environment for corporate financing. Still, because it has little effect on inflation, others see the policy as unable to satisfy its primary purpose.